Educational Articles

Free Cash Flow

Paul E. Debbas, CFA
| December 07, 2010

It is understandable that most investors examine a company’s earnings when evaluating its common stock. Earnings often influence stock prices. But there are other things that investors can consider when evaluating a company’s prospects. One of them is free cash flow.

The bottom line tells investors how much money a company made (or lost) over a specified time period. However, reported earnings can be affected by accounting methods, and don’t indicate how much cash a company is generating. Some expenses, such as depreciation and amortization, reduce corporate profits, but do not lower cash flow.

Value Line defines cash flow per share as earnings per share plus depreciation and amortization per share. For many companies, this is a good approximation of actual cash flow. But some items, most notably deferred taxes and investment tax credits, are included in a company’s true cash flow but not in the Value Line definition. That’s why Value Line uses quotation marks in its presentation of “cash flow” per share.

Even with this limitation, the statistics on the Value Line page can be used to provide a gauge of a company’s free cash flow. We define free cash flow as “cash flow” per share after capital spending and common dividends are subtracted. This is not the only way to define free cash flow. For instance, some investors segregate “growth” capital spending from “maintenance” capital expenditures (the capital spending needed to keep ongoing operations running) and subtract just the maintenance capital spending. An investor can do this only if the company has provided a breakdown of maintenance and growth capital spending, however.

Some industries typically generate free cash flow, and some typically have negative cash flow. Most of the stocks in the Household Products Industry, such as Clorox (CLX), have “cash flow” that exceeds the sum of capital spending and dividends. This is not surprising, considering that this is not a capital-intensive industry. On the other hand, each company we cover in the Water Utility Industry, such as American Water Works (AWK), has “cash flow” that doesn’t even cover capital spending, much less capital spending plus dividends. This isn’t a problem as long as a company has access to capital. In some industries, such as the Electric Utility Industry, companies can have positive or negative cash flow due partly to whether a major construction project is under way. For example, Cleco (CNL) had significantly negative free “cash flow” in recent years as the company built the largest project in company history. Now that the project has been completed, however, we estimate that free “cash flow” will be positive in 2010 and 2011.

Companies that generate free cash flow have several options for the use of their cash. They can use the funds to reduce debt, increase dividends (or declare a special dividend), buy back common shares, or make acquisitions. (Note that acquisitions are not included in Value Line’s definition of capital spending.) Companies that still have traditional pension plans, rather than defined contribution plans, can also use cash to help fund the pension plan. FirstEnergy (FE), for one, has done this from time to time in recent years.

Subscribers to The Value Line Investment Survey receive a list each week with the title, “Biggest “Free Flow” Cash Generators”. These are companies that earned more “cash flow” over the past five years than was required to build plant and pay dividends. Many of these companies do not pay dividends, however, and thus are not necessarily suitable for every investor. We do not advise investors to buy a stock just because a company is generating free “cash flow”, or shun equities of companies that need to finance their capital spending requirements. Free “cash flow” is just one more tool that investors can use in evaluating stocks.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.